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- Don’t forget the European Central Bank rate decision on Thursday – although, much of it has already been discounted by markets.

In what will likely be viewed as another watershed moment for the Euro-Zone, the Italian constitutional referendum on Sunday, December 4, represents the start of what should be a volatile week for EUR/USD. Between the Italian referendum and the European Central Bank rate decision on Thursday, traders should have a lot of opportunity on both the long and short side of the market. Implied volatility for EUR/USD had increased considerably through the end of last week, with 1-week implied vol going from 9.55% the day after the US Presidential elections to 17.41% on December 2.

Needless to say, excitement is expected around the two ‘high’ rated events for the Euro this week, particularly Sunday’s referendum. Before the polling blackout period went into effect, ‘No’ leads by about 5%, with about 23% of the electorate undecided. So, while the referendum passing isn’t of the question, it’s looking increasingly unlikely.

Chart 1: Final Two Italian Constitutional Referendum Polls

What matters to traders, of course, is how will markets react? Traders should begin to look to their newsfeeds right when markets open at 17 EDT/22 GMT on December 4. While exit polls will be released earlier than this time, they have been historically inaccurate, missing badly on the Berlusconi’s chances in 2008 and on the Democratic Party’s chances in 2013. As such, we thinking waiting until the official polling results come out starting after 22:45 GMT may be the safest way to obtain referendum results. A litmus test may prove to be Milan, which has historically (for decades) leaned to the right; yet it views Italian PM Renzi favorably, recently electing a major who supports Renzi’s center-left policies. If Milan swings back to the right, then Renzi – and his desire for a ‘Yes’ result – would be probably be in trouble.

Chart 2: EUR/USD Weekly Chart (June 2014 to December 2016)

While a ‘No’ outcome would feed into the growing mindset that economic populism is sweeping the West’s advanced economic democracies, it would more or less keep the current political system in Italy in place; the status quo would persist. Markets might act worried initially, selling EUR/USD and Italian equities in the neighborhood 1-3% and 2-4% on the results. EUR/USD could move to test the 1.0462 cycle low established in March 2015. Particular attention should be paid to Italian banks, which are in focus given the significant amount of non-performing loans (NPLs) on their books, and that Monti dei Paschi is in the midst of a debt-to-equity swap. Steeper losses seem unlikely.

In the event of a ‘No’ outcome, EUR/USD weakness would likely result, but a run towards parity given the scope of the referendum seems minimal. Even in the event of Renzi resigning and with new elections resulting, political gridlock would remain, preventing any significant reform – including legislation to take Italy out of the Euro, if say the Five Star Movement came to power in the next elections. Conversely, the scope for lasting EUR/USD gains in the event of a ‘Yes’ outcome seems limited as well – there’s simply too much political risk elsewhere on the horizon. Markets will remain as worried they are about elections in France, the Netherlands, and Germany next year; or these concerns will get worse.

Moving into the latter half of the week, the ECB meeting is expected to bring about significant changes to the ECB’s bond-buying program. At a minimum, the ECB will announce a six-month extension, extending the duration of its QE operations from March to September 2017. Any downside from this announcement has already been priced-in to the Euro, by our estimates; the formal recognition of this policy adjustment itself should have little impact on the Euro.

To ensure “smooth implementation” of its policies, the ECB will likely make an adjustment to its deposit floor threshold or capital key allotment. As a reminder, the ECB allots its bond buying based on the capital key. What is the capital key? The capital of the ECB comes from the national central banks (NCBs) of all EU member states. According to the ECB, the NCBs’ shares in this capital are calculated using a key which reflects the respective country’s share in the total population and gross domestic product of the EU.

As such, it's no surprise that Germany - as the country with the largest capital key contribution - has seen the belly of its yield curve (3Y-7Y) drift into negative territory, below the ECB's -0.40% deposit level - the threshold at which the ECB no longer purchases bonds in its QE program. While scarcity is not a concern now, the fear of liquidity issues down the road are significant enough that the ECB wants to act now to eliminate said speculation.

Likewise, beyond extending its QE program, the ECB will either: remove the limiting parameter of -0.40% on its bond buying; or discard the capital key variable. In the first case, German yields would like move lower the fastest; in the second, peripheral yields like in Italy and in Spain. If the ECB doesn’t, the odds of the Euro rallying on Thursday will increase as markets speculate that the ECB isn’t delving deeper into its extraordinary policy-loosening toolkit. –CV

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